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The Compensation Conversation

The bear market has exposed the weaknesses in both the transactional and advisory business models.

When it comes to compensation, most advisors will be delighted to put 2009 in the rear view. After all, industry experts are predicting that advisors will pocket up to 25 percent less than last year -- no matter how you get paid. Commissions, fees -- in this market, there's no place to hide.

"They're going to be feeling it," notes Alan Johnson, who heads Johnson Associates, a compensation consulting practice in New York City. "While we've averted a catastrophe, we're still below 2008, even if we have a great second half of the year. You're going to be down, and that's no surprise to the broker."

But enough of looking back. What's more important is what lies ahead: a changing landscape, driven by a tougher fiduciary standard, that could change the way products are marketed and sold and how brokers are paid. It's not unthinkable that the controversial move to a higher fiduciary standard for brokers who give investment advice could come by the start of the year, according to many industry observers.

"The word 'risk' is all over. If you look at regulators around the world, one of the things that's very consistent is they believe the pay system should not encourage excessive risk," said Johnson. "Does the pay system encourage the recipient to take inappropriate chances? As you get to the advisor level, it's a question that will continue to resonate."

And the Obama administration's focus on regulation doesn't stop there. "The industry as a whole is waiting for the other shoe to drop," according to Bing Waldert, a director for Boston-based Cerulli Associates. "It's only a matter of time." Among the practices Waldert says are sure to come under scrutiny: retention bonuses and recruiting packages.

Waldert was right. On August 31, SEC Chairman Mary Schapiro in a one-page open letter to broker-dealer executives warned them about offering substantial inducements to potential recruits, including large up-front bonuses and "enhanced commissions" on sales of investment products. "Certain forms of potential compensation may carry with them enhanced risks to customers," she said pointedly in the letter.

At the least, the market meltdown and the regulatory climate have put the compensation conversation into high relief. "I think the world has changed," says Danny Sarch, president of Leitner Sarch Consultants in White Plains, N.Y. Among other things, Sarch expects "dramatic" changes in the 2010 compensation grids that will be unveiled over the next few months. In his forecast: a continuing focus on higher producers, a drive toward "product neutrality" and rewards for converting to a fee-based business model.

"Payout plans have always been used to drive behavior. If you believe, as I do, that there's going to be a change to fiduciary, you must continue to drive business to a fee-based model," Sarch says. "I also think they will continue to raise the bar so that the higher-end guys will be taken care of. The lower-end guys, by definition, will lose."

Likewise, Mark Elzweig, president of Mark Elzweig & Associates in New York City, expects higher levels of compensation in the 2010 grids for brokers with good assets who do in excess of $500,000 in production. The back story, he says, involves how the wirehouses will deploy their "scarce" resources.

"Even if they're not actually firing you, they're making it clear that they want you to leave," he said. "There have been mergers of big firms, overhead is rising, money is scarcer than it used to be, and if you want to stay at a major wirehouse, if you're grossing $400,000 or more, you can stay. Of course, they want you to do $500,000 or more. Otherwise, they're saying, your revenue doesn't justify our overhead and you should leave."

What of the perks that once were part of so many Wall Street packages? They haven't exactly disappeared. Early this year, UBS introduced a Financial Advisor Survivor Benefit, under which the company will give 75 percent of a high producer's gross to your survivor, up to a maximum of $2.5 million. More traditionally, there are still incentive contests and high producers continue to be sent on trips.

"It's very quiet now but it exists," says Elvin Turner, managing director of Turner Consulting in Bloomfield, Conn. "Compensation doesn't have to be stellar but it has to be rewarding. That's probably something that will never change."

Rethinking Compensation

Not surprisingly, the events of the last year have exposed the weaknesses in both the transactional and advisory business models.

"What happened in the fall and into the spring was scary. People stopped trading and wanted to talk -- and that's across the board," said Turner. "You can get paid for talking or you can talk for free and just kind of hang on and wait for people to trade. That's what's been going on."

Going forward, Turner expects the "talking" model to gain traction not so much because of organic growth, but as a result of assets migrating from the traditional model. A Cerulli Associates report in July notes that wirehouses lost approximately $1.5 trillion worth of market share in 2008 while independents gained ground.

"A lot is uncertain," added Waldert. The move toward alternative fees -- project fees, hourly fees, fees for financial plans -- has slowed significantly though it was a burgeoning trend just 18 months ago. "The challenge is always getting the client to write the check. If you pull 1 percent out of a portfolio, they don't see that," he said. "In difficult times, if a client has to write a check for a $500 retainer when he's down 40 percent, that's a lot more challenging."

With a move to a universal fiduciary standard, Waldert says the ongoing trend toward a fee-based business model will only accelerate.

"Increasingly, what our numbers bear out is if you want extreme financial success, it's playing at the top end, it's fee-based compensation, it's taking on fewer and wealthier clients and it's providing more financial planning."

Even still, the bear market has also exposed the weakness in advisory fees as a sole source of compensation, according to Matt McGinness, principal of San Diego-based Best Practice Research.

"Advisors have been forced to come to grips with a weakness in a model where anything that drags down the AUM is going to impact their income. For most advisors, there's a fundamental misalignment between where the bulk of the work comes in the relationship and when they get paid," he said. "Plus, as the client ages and draws down his portfolio, the advisory fee comes down as well even though the work may be more intensive. The advisory fee isn't the perfect solution."

To that end, McGinness expects advisors to start looking seriously at charging financial planning fees and "advice" fees in addition to AUM charges. In fact, he says, advisory fees on assets may come down in favor of higher advice fees.

"What the market has revealed to most clients is that the value the advisor delivers isn't necessarily in asset management, but in the broader advice they provide. Those advisors who do nothing but manage the money are generally the ones who struggle the most," he added. "It's entirely possible that the dramatic events of the last year will push the broader themes of creating a compensation model that aligns revenue with expenses and also creates a compensation model that makes it easier to justify asset-based fees."

Tough Transition to Fiduciary Standard

Meanwhile, the immediate headline that will dominate the compensation conversation over the next months involves fiduciary reform. As The Wall Street Journal pointed out recently: "Fiduciary Duty Hits the Street -- Sort Of."

It's the "sort of" part that's got the industry abuzz. At the moment, lobbyists are working Congress in an effort to influence what a fiduciary standard will look like. The outcome is anybody's guess, but it's generally believed that brokers will eventually be held to some such standard.

"Once health care is resolved and off the front burner, this is right up there -- front and center," said Lou Harvey, president of Boston-based Dalbar, who has followed the saga as closely as anyone. "I would say there's a very good chance that by the end of this year, we're going to have a reconciliation of basically the two standards out there: the know-your-customer suitability standard on the brokers' side and the fiduciary standard on the investment advisors' side. What that means for compensation is you're going to be one or the other. You're either someone selling for a commission or you're going to be an advisor working for a fee."

In Harvey's opinion, choice will come at an institutional level. If Merrill Lynch or Morgan Stanley Smith Barney top brass decide to keep their advisory force in the traditional sales commission model, as an example, Harvey says the firms will package their business in some way -- perhaps creating an RIA for their investment advisors and then selling that unit off to an independent broker-dealer.

"I suspect these firms will make an affirmative decision as to whether they want to be in the advisory business or not because that carries liability. That's the deep dark secret they never tell you," he says. "Being a fiduciary will jack their insurance premium through the roof."

Harvey says the transition to a fiduciary standard will be good long-term but will not come without short-term pain.

"You're going to have to go back to all your clients again, have them sign a new contract and you're going to have to answer the question again: 'Why did I lose money last year?' Depending on how the market comes back, it's hard work," he said. "Right now every advisor is viewed sort of with a 'Gee, is this guy here to help me or is he trying to generate a commission?' Once there's a clear standard, I think it will generate confidence and therefore more and more people will rely on financial advisors. It will dramatically expand the marketplace."